Cash flow can easily dictate the success or failure of any business. Law firms are beholden to the same need for consistent incoming funds as every other company. Yet the requirements for staying compliant even when getting paid are considerably more involved for law firms than in most other industries, creating a unique set of concerns and best practices.
Compliance rules and requirements abound in the legal profession and any area of accounting is a potential minefield of ethics violations and sanctions that can quickly complicate simple tasks like accepting payments. To make sure payments are accepted in accordance with local bar association or Law Society regulations it’s critical to be aware of possible pitfalls. Accepting funds of any kind, even retainers, should have a process in place to ensure compliance.
There are three primary ways law firms accept bill payments or retainers: cash, check, and credit card. Each presents its own set of compliance concerns and requires best practices be carefully followed in order to limit risk.
“Cash is king, or so they say. But not when it comes to law firms. Cash is notoriously hard to track once it exchanges hands and presents a variety of issues for lawyers.”
While depositing checks always comes with the potential for an error when depositing into the incorrect account, cash presents an even bigger risk of being commingled with personal funds. Forget to deposit a check and when you come across it, you’ll most likely know what client it belongs to. But find some forgotten cash and it’s easy to pocket it without recording the funds in the books.
If cash is found and recognized as a client’s payment, difficulty can arise if the client matter isn’t noted when the cash is deposited. Not knowing can leave it unclear what a client’s actual balance is. This lack of knowledge about the associated client matter can lead to duplicate billing, incorrect books and a lack of clear knowledge about the financial balances of the client.
Depending on the case and practice area, it can become necessary to accept cash. Some firms keep a cash ledger to handle these situations. If cash must be accepted, be sure to deposit the cash right away so it’s recorded accurately on the bank statements. Once deposited, the books will also need to be updated immediately. Otherwise, the monthly reconciliations will show a discrepancy.
Once the cash is accepted, a receipt is paramount. A receipt is essential for proper bookkeeping but will also provide a layer of protection if the client disputes what has been paid. By providing the client with a copy and getting a signature for your records, there is recorded, tangible proof of how much was paid should the client contest the amount down the road.
Receipts have the additional benefit of helping to prove compliance with jurisdictional limits on how much cash can be accepted. For example, the Law Society of Ontario and the Law Society of Alberta only allow lawyers to accept amounts less than $7,500 from their clients. Within the United States lawyers are required to report cash received over $10,000. Entering the exact amounts taken in creates a clear record in the event of an audit.
Accepting too many cash payments, even when properly alerting the appropriate authorities for larger amounts, can lead to more scrutiny and a higher chance of being audited. In the United States, the Internal Revenue Service (IRS) considers accepting a majority of payments as cash a red flag given the possibility of cash being diverted for personal use without paying taxes. If accepting cash, having the right documentation to support bookkeeping records is crucial for passing an audit.
If you need to accept cash, keep in mind these best practices:
“Checks are a better form of payment to receive than cash in terms of ability to track and potential compliance issues. Yet checks also present their own set of concerns, most of which are primarily caused by issues on the client’s end.”
When accepting checks and depositing them, the bank usually makes some or all of the funds available immediately. However, if the check doesn’t clear, the funds that were advanced are taken out of the account. This change needs to be immediately entered in the books to keep them accurate. Be mindful of bounced check fees as well, as these also need to be properly accounted for. The bookkeeping should reflect the same changes to an account as seen on the bank statement.
Some jurisdictions require funds be placed on hold until cleared by the bank, especially for retainers. In many instances, those funds will be placed into a trust during the holding period depending on local ethics requirements. This hold helps to prevent law firms from spending these funds before they’re truly available.
Fraudulent checks also cause problems with bookkeeping. There are times when a fraudulent check can clear if the owner of the account doesn’t catch the problem. If a lawyer processes a fraudulent check and considers the funds received, this must be rectified when the account owner realizes what has happened. Beyond needing to address this in the books, the funds at this point may have been spent. The law firm then has the burden of locating the client and trying to collect the amount due.
When dealing with checks, be sure to follow these best practices:
Accepting credit cards offers a host of benefits. Clients are a lot more willing to pay instantly when using a credit card over writing a check. Credit cards payments are usually deposited into an account within 48 hours, leading to a more even cash flow and helping to reduce the expense of collections. Clients can also benefit from this as well, especially those who can more easily hire an attorney when credit is an option.
For all the benefits of credit cards, there are a lot of reservations in the legal community when it comes to accepting them as a form of payment. External and internal points of concern raise a number of red flags for lawyers. If set up correctly, however, credit cards can be processed ethically and securely to better manage accounts receivable.
PROVIDER CHOICE & LINKED ACCOUNTS
The first piece of accepting credit cards is deciding what provider to use. While credit card providers are held to particular regulations and standards, they’re certainly not all created equal and some are better than others to help lawyers meet the compliance requirements of their profession.
Lawyers must take into account more than the normal considerations involved with deciding what card credit processor to use, such as transaction fees, equipment rental or lease and monthly minimums. The strict regulations of trust accounts mean law firms must also take into consideration how the funds are deposited. Legal trust accounts prohibit the commingling of law firm funds with client funds and staying compliant requires choosing a credit card processor who addresses this unique concern.
To maintain compliance and prevent commingling, the merchant servicer should be able to accept payments to two different types of accounts: a trust account and an operating account. While earned income is deposited directly into the operating account, retainers or client funds should go directly into the trust account.
One workaround you may be doing is depositing retainers into the operating account and then transferring to the trust account. This is not only discouraged but in many states a compliance violation, even if the funds are transferred immediately. Client funds should never be mixed with other funds. The easiest and most secure solution is to always keep the funds separate.
Credit card transactions generally come with fees charged by the credit card provider. It’s extremely important that the credit card processor never deducts these fees from the amount being received by the client. The funds that are being deposited should match exactly what the client has paid.
These fees should instead be paid from a linked operating account. Not all credit card providers are aware of this unique law firm requirement. Generally, providers who know about this need will also allow law firms upon request to pay the fees in a lump sum at the end of the billing cycle. This set up makes it easier to identify these charges as an expense and reduces the possibility of the amount being taken out of the individual deposits.
Chargebacks, an automatic withdrawal due to disputed or fraudulent transactions is another source of concern. These must be handled properly to maintain accurate bookkeeping. Whether or not the firm has already deemed these funds earned income, the books must be updated to show the chargeback.
In the event a chargeback occurs, the deduction should come from the operating account. Even if the original deposit was made to the trust account, you need to apply the deduction this way to avoid affecting client ledgers. Otherwise, a client’s account can overdraft if funds are no longer available.
Offering clients a way to pay with credit cards online can reduce the time it takes to get paid. However, online payments present an issue when a law firm has their accounting and billing functions separate. With this setup, online payments become very hard to track.
When someone uses a credit card to pay an invoice, once the card is processed the funds are deposited into the operating account. This takes care of the accounting side, but makes it hard for the billing system to know what invoice(s) the payment is for. Unless the programs are integrated, the payments must then be manually accounted for in the billing system.
CREDIT CARD BATCHING
Credit card servicers often batch credit card payments from different clients together in one lump deposit, similar to how multiple checks are batched on a single deposit slip at the bank. The difference is that with check batching, the firm knows who provided the payment as it is given to the firm directly. You can also have the matter identifier referenced on the check to easily see what client the payment belongs to, but for credit cards, this isn’t an option. When accounting and billing are part of two different systems, credit card batching can result in disaster when it comes time to perform reconciliations due to difficulty in figuring out what the payment was for.
To avoid this issue it’s helpful to have a mechanism in place to batch these items in the accounting system as well to reflect the batched deposit from the credit card processor.
When accepting credit cards as payment, follow these best practices:
Retainers ensure payments for lawyers prior to completing any work. These funds can be accepted in multiple ways (cash, check or credit card). Regardless of how they’re accepted, retainers generally go into a trust account to avoid any impropriety and compliance violations.
Some states require all payments, not just retainers, be placed into the trust account first so it’s important to be aware of your state’s requirements. As discussed earlier some states require a hold on trust account deposits that can’t be earned until the hold period has ended (usually 2-3 days). All of these funds become subject to the requirements surrounding trust accounts.
TRUST ACCOUNT COMPLIANCE
As part of these requirements of bar associations and Law Societies, funds must never be pulled from one client to cover another. Only the amount belonging to a particular client can be used, even if the money is pooled in a trust account with other clients’ funds. To keep this from happening, accurate bookkeeping is essential when taking in retainers to make sure the amount shown is correct and to avoid over-drafting.
When using an accounting system created for all general businesses or conducting accounting manually, be careful as many programs don’t have mechanisms in place to prevent over-drafting or commingling of funds between clients. When earning payment from trust and retainers it’s common for these types of errors to happen. Legal-specific accounting software takes these needs into consideration and puts a safeguard in place to avoid such occurrences.
For more information on trust accounting compliance, check out The Do’s and Don’ts of Legal Trust Management.
BILLING & ACCOUNTING
As with accepting credits, the separation of billing and accounting programs when dealing with retainers creates the potential for a compliance violation if they are not properly entered into both systems. Duplicating these entries not only creates more work for the staff but also increases the risk of error. If billing in one system and reconciling the books in another, there becomes a need for constant comparison to make sure the books are reflecting the accurate earning of funds.
Most states require retainers to be placed into a trust account, as the fees are earned as the work is performed and does not yet technically belong to the lawyer. Paying an invoice from a retainer requires some extra steps for compliance purposes. First, the trust account must be debited as either a check or transfer and the operating account must be credited with the same amount.
Next, the matter retainer and billing balances must be updated. And lastly, because the funds in the retainer are not yet the lawyer’s they are counted as a liability. Once earned, that amount must then be shifted to income on the general ledger.
Dealing with retainers, where funds belong to the client until earned, requires careful adherence to trust accounting regulations and these best practices:
No matter how a law firm accepts payments, the payments need to be properly recorded for both accounting and compliance reasons. For legal accounting, there is a very specific order in which payments should be applied when received. As payments are taken in they should be applied in the following sequence:
For lawyers, this means you could receive a partial payment and only have it go toward covering costs. For example, if a lawyer receives $400 out of a $2,000 bill, those funds should be applied in the order of the above list. In that scenario, a lawyer wouldn’t receive any actual income until the highest priority items have been covered.
General accounting tools like QuickBooksTM don’t utilize this concept and, instead, apply payments proportionally to each item. This can be manually corrected with adjustments. To avoid having to rely on someone going into the system to make the change, some firms create an invoice for each part (such as costs or fees) and pay the invoices in order of the above formula to ensure proper allocation.
Reimbursed costs are very different from an earned fee. If entered incorrectly into the system without following the right formula for applying payments, it is inevitable to encounter bookkeeping errors. Reports will be incorrect, including profit and loss statements and accounts receivable reports.
If the firm compensates parties based on income earned, that amount will also be incorrect. These improper entries can also make it difficult to see what cases were the most profitable to a firm. This can lead to making business decisions based off of inaccurate information down the road.
When allocating income always ensure partial payments are designated correctly and applied in the proper order for accurate firm accounting.
Bringing in income is the only way for lawyers to keep their doors open, but doing so is guided by unique rules and regulations not seen in other industries. Law firms face unique accounting requirements set by bar associations and Law Societies which call for adherence to best practices when accepting payments to avoid any violations or sanctions. When deciding whether to accept cash, checks or credit cards and how to take in retainer payments, be sure to address each area of potential compliance risks.